In this article you will find out more about bond investments:
After an investor has decided to own bonds, some additional questions will pop up: Single bonds or rather a basket of bonds via an ETF? And if so, which type of bonds should you choose? Corporate or government bonds? Investment grade or rather junk bonds with higher yield, also called high yield bonds? Long, intermediate or short duration bonds?
Bonds Provide Regular Fixed Income
A bond is a tradable asset representing a debt held by an investor (debt holder or creditor) against the promise of the borrower (issuer of the bond) to pay fixed or variable interests (coupon) at defined dates (e.g., monthly, quarterly, semi annually, yearly) and the principal of the loan at maturity. The coupon is influenced by the credit rating of the bond issuer (e.g., investors require higher coupons for higher risk of default), duration of the bond and the general interest level set by national banks. Usually, bonds are placed at face value (issue value) but can change price due to changes in interest rates or credit rating. What is certain, the bond will be paid back at par value at the maturity date of the bond and this certainty makes it interesting for investors.
Bonds' Role in a Diversified Portfolio
Everybody has heard of the volatility lowering effect of bonds in a well-diversified portfolio. The idea is simple: shares up - bonds down and when shares go down - bonds go up. That has been valid for long periods - but during recent months with national banks hiking interest rates to fight inflation in an aggressive way as never seen before, that rule didn't work well. Shares went down and - that's different - bonds as well. But still, over long periods of time the basic concept of bonds as calming position in a portfolio remains valid - they are kind of an insurance policy for stormy markets (see example below).
Investment Grade or High Yield Bonds?
Since you want to own bonds as portfolio protection for unexpected events, focus should be on best credit ratings (investment grade bonds) and not on junk bonds paying a higher coupon (or nothing at all in case of default). Besides, high yield bonds show similar behaviour during market turmoil as equity: both are usually facing sharp selloffs, meaning a strong positive correlation. Better accepting a lower coupon but higher safety level for your investment. Therefore, let's have a look at a different categorisation of bonds, also.
Corporate or Government Bonds?
Main bond issuers are corporates and governments. So, corporate or government bonds? Even corporate bonds with best rating cannot keep up with investment grade government bonds with regards to safety. A government can increase taxes - a company not necessarily its sales and profit. The higher risk profile of corporate bonds is compensated by a slightly higher yield - but don't fall for it. What you want is portfolio protection and assets which react differently to extraordinary events. If market conditions become rougher, investors usually liquidate positions in corporate bonds and especially high yield bonds the same way as equity.
Past Performance of Corporate and Government Bonds During Market Turmoil
Let's take a look at two liquid and cheap Vanguard bond ETFs and how they performed during Corona lock-down when markets plummeted in 2020:
Vanguard USD Corporate Bonds (ISIN: IE00BZ163K21 - yellow line) vs.
Vanguard USD Treasury Bonds (ISIN: IE00BZ163M45 - red line) vs.
Worldwide equity market (purple line)
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While worldwide equity markets collapsed in February / March 2020 (dropping by about 35%-age points - see purple line), Corporate bonds initially held up but then also lost in March 2020. In contrast, USD treasury bonds did perform quite nicely and even gained about 5%-age points.
A similar effect can be seen since the beginning of the Russian war against Ukraine in February 2022.
Click to enlarge!
While equity markets went down starting mid of January 2022, bonds were rather stable with US Treasury ETF even increasing its value (see yellow line).
The two examples above might have provided good reasons for keeping some liquid and low-fee government bonds with investment grade rating in your portfolio.
High yield and corporate bonds behave similarly like equities and therefore, investment grade government bonds should be the preferred option for investors to diversify their portfolio.
The next question to answer is if bond investing should be done via single bonds or rather via a low-cost and very liquid bond ETF.
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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